Project Aspire
Based on the given facts, there are two investment proposals for the company (AYR Co) so as to enhance the value of the company. These two projects are named project Wolf and project Aspire. market research for both these projects has already been conducted by the company and based on the information available capital budgeting analysis needs to be performed based on which the company can take a decision with regards to choosing a superior project.
it is imperative to note that the superior project would not be selected only on the basis of quantitative parameters but qualitative parameters would also be considered. the aim of the given report is to present an analysis of the given projects using the various Tools and techniques of capital budgeting along with relevant qualitative aspects. Alongside, the report food also focus on the various means of Financing that may be availed with emphasis on the respective merits and demerits.
Capital Budgeting Techniques
for the application of appropriate capital budgeting techniques, the vital first step is to estimate the post-tax incremental cash flows that are expected to arise from each of these projects over the respective useful lives.
Project Aspire
A pivotal information with regards to the project is that the company has spent $120,000 on market research which would be categorised as sunk cost as irrespective of the project decision this particular cost cannot be recovered by the company. Since this cost is labelled as sunk cost and it would not be considered as part of the incremental cash flows arising from the project (Damodaran, 2015).
Taking into consideration the relevant information available, it is evident that the useful life for the project is five years. The initial capital expenditure for the project is expected to be $2.25 million which would be incurred primarily for plant and machinery acquisition. Besides, there would be requirement of incremental working capital to the tune of $140,000. This incremental working capital used for the project would be fully recovered at the end of the project. The plant and machinery purchased at the start of the project are expected to have a salvage value of $375,000 at the end of 5 years.
The annual depreciation expense needs to be computed despite being a non-cash expense as it leads to lowering of pre-tax income and hence acts as a tax shield.
On the basis of the market research conducted, it can be concluded that the project which generate incremental sales for which incremental variable cost would also be undertaken and the precise estimates are available for the same. On account of the capital expenditure that the company would undertake for the project, it would obtain tax benefits in the form of capital allowances which would provide tax shield and thereby lower the tax outflow on any incremental profit that are generated from the project. A noteworthy feature about the project is that the tax payment would occur in arrears which imply that the tax on Profit generated in a given year would be paid the next year.
Net Present Value (NPV)
The incremental cash flow generated from the project are highlighted in Appendix 1. The following capital budgeting techniques would be applied taking into consideration the incremental cash flows expected to be generated from the project as shown below.
Net Present Value (NPV)
NPV is defined as the total sum of present value of the incremental cash flows that are expected to be generated from a given project during the useful life (Parrino and Kidwell, 2014). A relevant input required for computation of NPV is discount rate which is important considering the fact that NPV takes the time value of money into consideration. The discount rate for the given project is given as 10%. The NPV computation is summarised in the tabular manner as shown below.
Based on the computation conducted above it is apparent that the NPV for the given project is $ 1,842,091.
Internal Rate of Return (IRR)
The discount rate which leads to the NPV value of zero is known as IRR (Arnold, 2015). The IRR computation has been carried out in the table shown below.
The computation carried out below clearly highlights the IRR as 37.12%
Payback Period
The payback period is defined as the necessary time which is required for recovery of the initial investment. In the context of the given project the initial investment would comprise of capital expenditure in the form of plant and machinery along with working capital which is necessary for production of final goods. The payback period computation is summarised through the use of the following table (Northington, 2015).
Project Wolf
Based on the information obtained from the market research, it is apparent that the initial investment for the given project would amount to $ 2.25 million. However, for this project no capital allowances are available. For this project, any assets that have resulted in the initial outlay have zero salvage value at the end of five years. The first objective is to estimate post-tax incremental cashflows on the basis of the information provided.
Further, for the project under consideration, an opportunity cost would be incurred on an annual basis since the company would have to lose the rental income it is currently earning as the premises would be used by the company for the project (Berk et. al., 2013).
The incremental cash flow generated from the project are highlighted in Appendix 1. The following capital budgeting techniques would be applied taking into consideration the incremental cash flows expected to be generated from the project as shown below.
Net Present Value (NPV)
NPV is defined as the total sum of present value of the incremental cash flows that are expected to be generated from a given project during the useful life (Parrino and Kidwell, 2014). A relevant input required for computation of NPV is discount rate which is important considering the fact that NPV takes the time value of money into consideration. The discount rate for the given project is given as 10%. The NPV computation is summarised in the tabular manner as shown below.
Internal Rate of Return (IRR)
Internal Rate of Return (IRR)
The discount rate which leads to the NPV value of zero is known as IRR (Arnold, 2015). The IRR computation has been carried out in the table shown below.
The computation carried out below clearly highlights the IRR as 21.80%
.Payback Period
The payback period is defined as the necessary time which is required for recovery of the initial investment. The payback period computation is summarised through the use of the following table (Lasher, 2017).
Detailed Analysis
- For each of the two projects under consideration, the initial investment is the same and since the company can fund only one of the two projects, the given situation makes the projects as mutually exclusive. Under the given situation, the superior project ought to be selected based on the result of the application of the various capital budgeting techniques. These computations lead to the conclusion that the superior project is Aspire instead of Wolf as all the capital budgeting techniques seem to favour the former over the latter (Brealey, Myers and Allen, 2014).
- A detailed explanation of the superiority of the various key parameters is offered below.
NPV – With regards to NPV, the feasibility of the project is linked to the positive value of NPV. A project with positive NPV is expected to increase the firm value and thereby prove beneficial for the shareholders. For the projects under evaluation, the NPV is positive and therefore each of the projects is financially viable. However, owing to the requirement of choosing the superior project, Aspire would be the preferred bet since a higher NPV is registered for this project as compared to Wolf (Kane and Marcus, 2013).
IRR – The underlying requirement for a financially feasible project is that the cost of capital must be lower than the corresponding IRR. This would ensure wealth creation for the shareholders. In the case of both the projects under consideration, the respective IRR is higher than 10% which implies that feasibility is evident for the two projects. But since the company can implement only one project, hence Aspire would be a preferred bet as its IRR value tends to be greater than Wolf (Northington, 2015).
Payback Period – The financial feasibility of a project is established when the computed payback period tends to be lesser than the project life. Considering for that the project life for the two projects is five years and the respective payback periods are smaller, it is apparent that the two projects have been successful is establishing their financial feasibility. But since the company can implement only one project, hence Aspire would be a preferred bet as the payback period for the same is lesser than payback period for Wolf (Gitman, Juchaou, and Flanagan, 2017).
- On the part of the company, it is critical that the investment decision must give appropriate weight to the qualitative parameters associated with the evaluation. These are highlighted below (Graham and Smart,2012).
- Project scope is one of the key aspects that ought to be considered. Under Aspire, the main focus of the company would be the existing customers as the company would launch new products which are related to the current product offerings. Thus, the value generation from this project would be on the basis of higher revenue generation from each customer rather than targeting new customers. The scope of Wolf is quite different considering that it would target new customers since a new business would be started whose target segment would be separate. Hence, from strategic significance, Wold project would have a edge as it would open immense cross sale opportunities along with ensuring business diversification which is considered a healthy risk management practice. Hence, implementation of Wolf project would ensure that there is a natural hedge to any downside in the existing business. Therefore, from a strategic perspective, the superior project would be Wolf and not Aspire.
- Yet another crucial aspect is the strategy adopted by the competitor coupled with evolving market trends. Strategic planning typically requires decisions that are driven by long term vision and responding to structural changes in the market in a proactive manner. The future of the current business 5-7 years down the line ought to be considered along with the possible strategy of the peers before deciding whether business diversification is required or not. Businesses where technology tends to play a critical role are prime examples of such businesses (Brealey, Myers and Allen, 2014).
Based on the discussion carried out above, it seems that on account of qualitative aspects, the superior choice would be Wolf considering that it would result in business diversification and aid in risk management. However, on account of the qualitative aspects, Aspire scores over Wolf. As a result, it is imperative that the relevant decision makers must accord relevant significance to both the aspects and take a decision based on the respective weights and priority given to the two factors (Ehrhardt and Brigham, 2016).
Finance Sources – Debt & Equity
- Two most prominent financing options available to businesses are debt and equity. In case of debt based financing, there is raising of debt which needs to be repaid besides making interest payments periodically (Damodaran, 2015). In case of equity based financing, the finance is sharing by the issuance of equity shares or by selling ownership of the underlying business. As consideration is provided in the form of ownership, hence the money raised through this means need not be repaid and no interest is levied (Arnold, 2015). The obvious issue with regards to equity based financing is that promoters may lose control. With the issue of debt also risk is associated in the form of potential credit default and hence for each of the two financing sources there are potential pros and cons (Christensen et. al., 2013).
- From the perspective of a lender, interest payments would provide the returns as this is the extra money received over and above the principal repayment. The returns realisation for equity investors differs significantly as return may be in the form of dividend receipt or appreciation of capital
This is quite different from investors of equity where the returns tend to be realised as two main modes i.e. receipt of dividend and capital appreciation of the share value owing to increase in the firm value. A key difference is that there is no assurance of dividend payment unlike interest payments which are assured (Northington, 2015).
The cost of financing associated to each means is linked to the underlying risk associated with each of the two sources. In accordance to the portfolio theory, for investments having a higher risk, the issuers typically tend to provide higher returns as an incentive to find interested investors. For equity investors, the underlying risk is higher as the amount provided is not returned and also there is no assurance for any capital appreciation or dividend payment from the company. In case of failure of business, liquidation proceeds are also not received by equity investors as they are last on the priority list (Brealey, Myers and Allen, 2014). The higher risk implies that equity investors would desire a higher return than corresponding debt investors as the latter tend to assume lower risk than the former (Brigham and Houston, 2014).
Payback Period
In case of lenders, the repayment of debt is usually guaranteed owing to the existence of a collateral which may be liquidated for recovery of debt if the company fails to relay the same. Also, in liquidation cases also, the priority given to lenders is higher than equity investors which imply greater chances for recovery of outstanding debt repayments and interest payments outstanding. The lenders also have the option to recall debt in case of breach of any debt covenant (Ehrhardt and Brigham, 2016).
Based on the above discussion, it can be concluded that risk for equity investors is considerably higher than corresponding debt providers and hence the former expect a higher returns than the latter.
- It is apparent that the WACC for the given firm is 10%. Further, the current capital structure preferred by the company comprises primarily of equity with less contribution from debt.. In order to raise the incremental fund requirement, the company has the following choices..
Equity financing (100%) – In this case, no debt funding is used and finance cost is higher considering the equity is more expensive than debt owing to higher risk associated. The viability of the chosen project would undergo an adverse impact owing to higher WACC. Based on the above, this financing means is not appropriate choice (Berk et. al., 2013).
Debt financing (100%) – In this financing choice, the obvious advantage would be lower cost but there would be quite high interest payment that would have to be regularly paid. Also, the balance sheet may become overleveraged and hence this option ought to be avoided (Murray and Goyal, 2008).
Considering the above choices, it makes sense for the company to opt for the mix of debt and equity in the same proportion which it exists currently which would yield a WACC of 10% for the project.
- Various stakeholders would be impacted by the financing choice exhibited by the company as has been highlighted below.
Equity Financing – In this, there would be dilution of equity shares for the existing shareholders. Besides, higher shares outstanding could lead to lower EPS especially as there may be a time lag in generation of incremental earnings on account of the project. Further, if the project related earnings are not realised then the shareholders wealth would be adversely impacted (Lasher, 2017). Excessive dilution could lead to loss of control by the promoters thereby having adverse impact on the realisation of long term goals for the business. Also, a higher WACC would lead to incremental risk for the project. Equity financing would be considered as positive for the debtors of the company as it would leave to lower financial risk and encourage overall deleveraging of the balance sheet thereby reducing the risk of default (Brealey, Myers and Allen, 2014).
Debt Financing – There is regular payment of debt which would lower the profits and hence adversely impact the EPS and potentially the share price especially if the incremental earnings expected from the project are not realised as per expectations (Christensen et. al., 2013). The issuance of debt would lower the WACC and hence would serve the interests of the shareholders if the balance sheet is not over-leveraged. The taking of extra debt would be negative for the lenders as the ability of the company to service the debt of existing lenders may suffer owing to incremental interest commitments and repayments to be made (Kane and Marcus, 2013).
The above discussion clearly brings forth the futility of excessive reliance on any one means of financing and instead opting for a healthy mix of the two sources taking into considering the current balance sheet strength and debt servicing ability of the company
Conclusion
On account of the analysis conducted in previous sections, it is apparent that capital budgeting techniques tend to favour the Aspire project but the qualitative parameters tend to favour Wolf project. The final decision needs to be taken by providing the requisite weightage to both factors considering the current & future priority. In the context of raising finance, both debt and equity have their advantages and limitations and thereby it is best for the stakeholders as a whole that a healthy mix of the two is preferred for project funding.
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